A study shows repealing itemized deductions and increasing the standard tax deduction would result in a tax cut for half of the state’s taxpayers, yet still would raise an estimated $404 million a year

RALEIGH (Aug. 24, 2010) -- Itemized deductions cost North Carolina about $400 million in income tax revenue annually while undermining the fairness of state tax systems, a new report shows.

Plus, federal tax changes enacted during the presidency of George W. Bush have gradually made itemized deductions even more unfair and expensive over the last five years, automatically passing tax cuts onto North Carolina's wealthiest residents even as the state faces unprecedented budget challenges. Reform could play a positive role in making North Carolina's tax system fairer and more sustainable.

“No lawmaker would ever devise a spending program to encourage homeownership that gave the biggest checks to the richest taxpayers, while entirely excluding low-income families,” said Edwin McLenaghan, a policy analyst with the NC Budget & Tax Center. “Yet itemized deductions have exactly that effect.”

A new report from the Institute on Taxation and Economic Policy, "'Writing Off' Tax Giveaways: How States Can Help Balance Their Budgets by Reforming or Repealing Itemized Deductions presents estimates of the yield and tax fairness impact of five approaches to itemized deduction reform in the states, each of which would raise significant revenue to fund vital public services and make state tax systems less unfair.

Itemized deductions were designed to help defray a wide variety of personal expenditures that affect a taxpayer’s ability to pay taxes, including charitable contributions, extraordinary medical expenses, mortgage interest payments and state and local taxes. Yet the deductions undermine the fairness of state tax systems: low-income families receive virtually no benefit from these deductions, and the biggest benefits are reserved for the upper-income families who arguably need them the least.

The most comprehensive reform approach available to states is simply to repeal all itemized deductions and ensure that most middle- and low-income families are held harmless by simultaneously increasing the basic standard deduction available to all families, a step taken this year by the Rhode Island legislature.

Repealing itemized deductions and significantly increasing the standard deduction in North Carolina would result in a tax cut for half of the state’s taxpayers, yet the reform still would raise an estimated $404 million a year.

North Carolina’s state income tax currently includes all federal itemized deductions because it uses federal taxable income as the starting point. Moving the starting point to federal adjusted gross income and significantly increasing the standard deduction in North Carolina would save the state funds while making the tax system more fair.

The report presents four additional reform options, most of which have been enacted in some form in a number of states: capping the total value of itemized deductions, converting itemized deductions to credits, enacting stand-alone phaseouts, and decoupling from the recent federal tax changes.

“North Carolina policymakers can ill afford to maintain these costly and unfair tax breaks in their current form," said McLenaghan. "By enacting common-sense itemized deduction reforms, lawmakers can prevent federally-imposed tax cuts for the wealthiest few from busting the budget—and can raise substantial revenues to fund needed public investments.”